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Reforming the law on director's duties

Introduction

Director’s duties have received considerable attention over the years and are presently pending reform, largely in the form of a statutory statement of duties.[1] This essay will consider the common law development of directors’ duty of care, skill and diligence together with the effect thereon of statutory provisions such as the Insolvency Act 1986 (“IA 1986”) and the Company Directors Disqualification Act 1986 (“CDDA”). This essay will also refer to some international responses to the issue of low standards set by the duty of care and skill and consider whether codification is the solution thereto.

Prior to defining a director’s duty of care and skill, it is first important to define the term “director”. In the Companies Act 1985 there is no definition of “director”. In accordance with section 741 (1) of the Act, the term includes any person occupying the position of a director, by whatever name called. An important distinction is made between executives and non executive directors. Non-executive directors are not employees, and are not expected to devote their full time to the company. Executive directors however, are required to be involved in the day-to-day management of the company and normally have extensive management authority. Despite the distinctions between directors being an important matter of business practice, it has less validity in company law, as both are subject to similar legal duties and responsibilities.

Their common law duty is to run the company with appropriate care, skill and diligence and without negligence. It has been argued common law gives directors too much freedom to manage companies incompetently.[2] Academics such as Mackenzie states that, “In addition to the heavy duties of loyalty and good faith with which a company director must abide, the common law further provides more lenient obligations of diligence, care and skill, formulated on broad principles rather than comprising detailed rules and owed to the company and not to individual members.”[3]

A development of the Duty

Most reported cases were decided in the early twentieth century, prior to the existence of “professional” company directors. It is perhaps arguable that for this reason the standards presently imposed on directors are surprisingly low.

The starting point is the judgment of Romer J in the case of Re City Equitable Fire Insurance Co Ltd.[4] Despite the fact this case was heard in 1925, it contains a useful review of the early authorities. Furthermore, it helped reduce the main principles relating to the duty of skill and care to three main principles.

Firstly it was held that, “a director need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience”.[5] This effectively meant that there was no objective standard of the reasonable director and is illustrated in Re Denham & Co[6] where a country gentleman director failed to study a set of accounts subsequently proposing a dividend that was paid out of capital. He was not liable in negligence as he could not be expected to realise the significance of the accounts.

Secondly, it was held that “a director is not bound to give continuous attention to the affairs of his company. His duties are of an intermittent nature to be performed at periodical board meetings….He is not, however, bound to attend all such meetings, though he ought to attend whenever, in the circumstances, he is reasonably able to do so.”[7] It is clear that this proposition, as in the first, will often be expressly or impliedly displaced. In fact, in Re Cardiff Savings Bank, (The Marquis of Bute’s Case)[8] a figurehead director who failed to attend board meetings, and failed to prevent the active director from conducting the company’s affairs improperly, was held not to have been negligent. However, as is illustrated by the case of Dorchester Finance Co Ltd v Stebbing,[9] such result is unlikely to be obtained today. In the Dorchester case, failure to participate in the company’s activities and the resulting failure to discover the defaults of the managing director on the part of the directors in question were considered negligent.[10]

Thirdly, “in respect of all duties that, having regard to the exigencies of business, and the articles of association, may properly be left to some other official, a director is, in the absence of grounds for suspicion, justified in trusting that official to perform such duties honestly.[11] This meant directors escaped liability in instances where subordinates to whom they had properly delegated functions relating to the company’s finances, misrepresented the company’s financial position resulting in directors paying or recommending the payment of dividends out of capital.[12]

There remain echoes of the three propositions referred to in the Re City case in more recent authorities, although arguably, the law is now moving towards a more objective and thus demanding a higher standard of care and skill from company directors. An objective standard of care and skill is required in any event of a director employed under contract of service that is an executive director. Accordingly the discussion below, refers to the position of non-executive directors.

In the Dorchester case, Foster J applied the propositions as set out in the Re City case, but held that non-executive directors who were either qualified accountants or who had considerable accountancy and business experience had been negligent in signing blank cheques allowing the managing director to misappropriate the company’s money. This points towards the recognition of the concept of the professional director, although, in contrast, the legislature declined the opportunity at that time to impose an objective standard on some company directors. More recently the Privy Council in f Kwait Asia Bank EC v National Mutual Life Nominees Ltd [13] cited Re City with approval, repeating the proposition that directors were only liable for gross negligence.

The common law development has been slow to change. Accordingly, the influence of section 214 IA1986, particularly of subsection (4) (a), requiring a director to display a higher standard of skill and care lest he be found liable for wrongful trading, is of particular importance in helping to strengthen the law in this area.

Despite the fact liability for wrongful trading may be imposed only when the company is in insolvent liquidation, this provision has been cited by Lord Hoffman in two recent decisions[14] as an accurate statement of the director’s common-law duty of care and skill. In Norman Theodore Goddard[15] the court held that, provided the director observed the standard set out in section 214, he was entitled to trust people in positions of responsibility until there was reason to distrust them. On the other hand, in Re D’Jan of London Ltd[16]the court held that a director who signed an insurance proposal form without checking its contents was considered as negligent. In Re Simmon Box (Diamonds) Ltd[17] the only director of the company, who abjectly surrendered to the person who acted as de facto director, was held to have been negligent, as was the director in Re Westlowe Storage and Distribution Ltd[18] who failed to ensure that the company benefited properly from the transactions it was engaged in when it was his responsibility to ensure that a proper accounting system was in place.

It is suggested that there is a development in the approach of the courts, not just in cases of wrongful trading, but throughout the company’s existence. The test, as found in section 214 (4) of the IA 1986 imposes an objective test on the duties of care, skill and diligence, and Hoffmann’s LJ’s application thereof in the above recent cases[19], could be significant.

The Re City case has been criticised for imposing lenient duties on directors which do not reflect today’s modern company. Fisher in particular has argued that the duty of care as described by Romer J, is of an objective nature, and the duty of skill is subjective, but the “fusion of these elements into a comprehensive duty has allowed the subjective degree of skill to overshadow the objective duty of care.”[20] More importantly, Boyle argues that “the classical statement of Re City Equitable is both unsatisfactory and inappropriate to the needs of the modern business world.[21]

The application of section 214 in the two Hoffman decisions may indicate the courts are clarifying their position regarding the duties of care, skill and diligence. Notably most of the older cases involved part-time or non executive directors, such as in the Re City case. It has been suggested by Pennington[22] that the court was right in such instances not to impose very high standards on such individuals who were merely non-executive. Pennington further states that it should also be recognised that those decisions should not form a reliable guide, as most recent cases involve directors who are employed under a service contract, in a full-time capacity and who might be specialists in their field.[23]

It means that the recent decision in Dorchester is an important development, as the judge emphasised active participation is required from directors, including the non-executive ones, and the standards expected are even higher when they have specialised skills. Foster J rejected the argument that non-executives could allow an executive to have absolute control and held that in the Companies Act 1985 the duties of executives and non-executives were the same. This case has been described as “going further than most older cases and heralds a stricter attitude on the directors’ negligence.”[24] It also clarified the expected duties of non-executive directors by stating that they are under that same type of duties as executives and the same level of care, skill and diligence is required from them.[25]

So what else has had a strengthening effect on directors’ common law duties of care and skill? The duties owed by directors to creditors under the IA 1986 have, as will be demonstrated below, had an effect, if only limited, on director’s duties. One of the concerns of Parliament has been the protection of creditors against the abuse of limited liability by company directors. The general obligation of company directors to take into account the interests of creditors[26] is supplemented by sections 213 and 214 IA 1986. Section 214 aims at motivating directors to face up to a financial crisis before it is too late, and as a result, it is anticipated that this will reduce losses to creditors. The principal aim of section 214 is to improve the standards of competence and conduct among directors. However, the impact of section 214 on the duties of directors can only be limited. As emphasised by Finch, the wrongful trading provisions catch only a “limited span” of negligent conduct, in that, what is covered is the failure of directors to take proper steps to protect the company’s creditors “beyond the point when the company’s failure seemed inevitable.”[27]

Creditors may act as outside enforcers of the duties of care, skill and diligence. However, there are a number of weaknesses in the wrongful trading provisions, including the fact that claims for wrongful trading are not often brought against directors disqualified under section 6 of the CDDA 1986, which limit the effectiveness of section 214 in increasing the general standards of competence.[28]

Unless these weaknesses are reduced, it is difficult to assess the impact that such section may have on the general duties of care, skill and diligence of company directors through creditors as outside enforcers.

What about the provisions of the CDDA? Have these helped strengthen the duty of care and skill? The aim of the CDDA as with the wrongful trading provisions of the IA 1986, is the protection of creditors from the abuse of limited liability by company directors.

Legislation in unable to change common law duties and is unlikely to have a direct impact on them. The CDDA may however, supplement the common law rules by establishing better standards of practice. Under section 6 of the CDDA, a director is disqualified from managing a company if he has been a director of a company that has become insolvent and in accordance with the law, his conduct makes him unfit to be concerned in the management of a company.

Lord Woolf MR explained in Re Blackspur Group Plc[29] that the purpose of the CDDA was “the protection of the public, by means of prohibitory remedial action, by anticipated deterrent effect on further misconduct and by encouragement of higher standards of honesty and diligence in corporate management from those who are unfit to be concerned in the management of a company.”

In considering the decision in Re Barings Plc & Others (No 5)[30] it may be concluded that the CDDA supplements the duty of “diligence” as well as to some extent the duty of “skill”. However, breach of the duty of “care” may not often be a ground for disqualifying company directors. The courts disqualify individuals for failing to properly supervise, for irresponsibly delegating their obligations, or for failing to be actively involved in the affairs of the company. If may further be suggested that the idea that directors must have sufficient awareness of the company’s financial position is well established in disqualification cases.

The implication drawn from decisions such as that in Re Park House Properties Ltd[31] and Re Peppermint Park Ltd[32] is that directors may think twice prior to occupying a position without proper knowledge or without intending to take an active part in the company’s affairs.

There however, reason to think the disqualification regime may be failing in some respects. Research conducted by Hicks[33]and by the National Audit Office[34] show that there are several problems weakening the positive impact of disqualification on the current standards of practice, including the general problem of awareness and influence. Perhaps until directors can, via proper awareness, be positively influenced by the CDDA, its impact is limited to its protective value only.

The Law Commission’s report on director’s duties, proposes a statutory statement of the duties of care, skill and diligence of company directors, so as to bring more certainty and clarity into the applicable standards.[35] Arguably the influence of the disqualification provisions is valuable as it comes from a statutory source and accordingly provides more certainty into the expected standards. Nonetheless, until such statutory statement is enacted, the role of the courts in supplementing the duties of care, skill and diligence through the disqualification cases, remains of some importance.

Could the adoption of a US based business judgment rule also help strengthen director’s duties? This has not been recommended by the Law Commission. In relation to commercial decisions in general, the courts already adopt a policy of not reviewing commercial decisions or “question the correctness of the management’s decision….if bona fide arrived at.[36] Despite the fact there may be some benefits attached to the rule there is ambiguity as to its role in practice. Problems arise including the extent of the use of insurance and the possible limitation of liability. More importantly, the rule only applies to particular commissions, and most United Kingdom cases are concerned with omissions. Since there is already an “implied” commercial judgment rule in the United Kingdom, found in the fact that the courts are not willing to review decisions of directors on commercial judgments arrived at bona fide, the introduction of the US business judgment rule is unlikely to be supported.

The Law Commission’s view is that if there were any evidence that the rule would lead to a raising of the standards of behaviour of directors, by for example “encouraging them to make appropriate enquiries, as opposed to making them more cautious, that would be a strong reason for having a business judgment rule”. [37] This has however, not been the case. Consultees were asked whether, assuming that director’s duty of care was made statutory there should be a statutory principle of non-interference by the courts in commercial decisions made in good faith. A small majority of respondents were against the introduction of the rule into statute, mostly because the courts already respect commercial decisions under general law. Accordingly, it was concluded that it is not necessary to codify it and that this principle is best left to be developed by the courts.

What about the effect of Corporate Governance on the duty? The South African initiative, King Report I (1994) and King Report II (2002), is one of the most advanced Codes of Corporate Practices and Conduct. The purpose of the Reports was and remains to promote the highest standards of corporate governance and herein lies their importance, in realising the world today expects more of companies and their directors.

Unlike its counterparts in other countries at the time, the King Report I went beyond the financial and regulatory aspects of corporate governance in advocating an integrated approach to good governance in the interests of a wide range of stakeholders having regard to the fundamental principles of good financial, social, ethical and environmental practice. In adopting a participative corporate governance system of enterprise with integrity, the King Committee in 1994 successfully formalised the need for companies to recognise that they no longer act independently from the societies and the environment in which they operate.

The significance of corporate governance is now widely recognised. Companies are governed within the framework of the laws and regulations of the country in which they operate. Communities and countries differ in their culture, regulation, law and generally the way business is done. In consequence, the World Bank has pointed out, that there can be no single generally applicable corporate governance model. Yet there are international standards that no country can escape in the era of the global investor. Thus, international guidelines have been developed by the Organisation for Economic Co-operation and Development (OECD), the International Corporate Governance Network, and the Commonwealth Association for Corporate Governance. The four primary pillars of fairness, accountability, responsibility and transparency are fundamental to all these international guidelines of corporate governance which notably positively affect a director’s duty of care and skill.

Conclusion

Company Law is presently undergoing major reform under the Company Law Review, which seeks to modernise the legal framework in which companies operate[38]. In March 2005 the government published a White Paper on “Modernising Company Law” setting out its proposals for reform. It is questionable whether the introduction of a statutory statement of duties as proposed will in fact strengthen the duty of care and skill. The government is of the opinion that common law rules have made it difficult for company directors to understand their obligations under the law and it is with this thought that the codification of director’s duties is employed. These duties will replace common law and are expected to be drafted “in a way which reflects modern business needs and wider expectations of responsible business behaviour.”[39] However, it remains to be seen whether this will in fact enable the law to respond to changing business circumstances and needs and whether it will leave scope for the courts to interpret and develop provisions in a way that reflects the nature and effect of the principles the code is to reflect.

As the law presently stands, it imposes only “a modest objective standard of care supplemented by a flexible subjective standard of skill.[40]

In their 1999 Report, the Law Commission supports the imposition of a statutory statement of the duties of care, skill and diligence and recommends that the standard should be judged by a twofold objective/subjective test[41] (based on section 214 IA 1986 because directors should have the same duties during the life of the company and as it approaches insolvency).

If the recent cases as decided by Hoffmann LJ represent the present state of the common law, a statutory statement of the duties would not significantly change the present applicable standards. When common law standards are carefully examined, it is evident that they already impose objective and subjective requirements. However, before fully understanding and appreciating what the law expects of them, company directors have to be acquainted with a vast number of cases and statutes including cases decided under the CDDA 1986. In this way it is arguable statutory codification may clarify the present standards making the law more accessible to directors, although it remains questionable whether any standards would in fact be raised.

Bibliography

Arsalidou, D, The Impact of Modern Influences on the Traditional Duties of Care, Skill and Diligence of Company Directors, 2001, Kluwer Law International

Davies, PL, Gower and Davies’Principles of Modern Company Law, 7th Edition, 2003, Sweet & Maxwell

Finch, Company Directors: Who Cares about Skill and Care? (1992) 55 MLR 179

Hannigan, B, Company Law, 2003, Butterworths

Hicks, A and Goo SH, Cases and Materials on company Law, 5th Edition, 2003, Oxford University Press

Pettet, B, Company Law, 2001, Longman

Riley, The Company Director’s Duty of Care and Skill: The case for an Onerous but Subjective Standard, (1999) 62 MLR 697

Sealy, LS, Cases and Materials in Company Law, 7th Edition, 2001, Butterworths

Modernising Company Law Cm 5553 (July 2002) www.dti.gov.uk

1


Footnotes

[1] Modernising Company Law, Cm 5553

[2] Finch, “Company Directors: Who cares about skill and care?” (1992) 55 MLR, 179

[3] A.L Mackenzie, “A Company Director’s Obligations of Care and Skill”, (1982) JBL, 460

[4] [1925] Ch 407

[5] Ibid at page 428. It was often said that a director was liable only for “gross negligence”.

[6] (1883) 25 Ch D 752

[7]Re City Equitable Fire Insurance Co Ltd [1925] Ch 407 at 429

[8] [1892] 2 Ch 100

[9] [1989] BCLC 498

[10] Re Simmon Box (Diamonds) Ltd [2000] BCC 275

[11] [1925] Ch 407 at 429

[12] Dovey v Cory [1901] AC 477

[13] [1990] BCLC 868 at 892

[14] Norman v Theodore Goddard [1991] BCLC 1028 at 1030-1031,and Re D’Jan of London Ltd [1993] BCC 646 at 648

[15] [1991] BCLC 1028 and see also Equitable Life Assurance Society v Bowley [2003] EWHC 2263 (Comm)

[16] [1993] BCC 646

[17] [2000] BCC 275

[18] [2000] BCC 851

[19] which was supported by Hart J in Re Landhurst Leasing Plc (1999) 1 BCLC 342 at 344

[20] S Fisher, “Reform of the Duty of Care and Diligence of Directors in Australia” (1993) 14 The Company Lawyer 145 at 146

[21] A Boyle, “Draft Fifth Directive: Implications for Directors’ Duties, Board Structureand Employee Participation” (1992) 13 The Company Lawyer 6

[22] R Pennington, Pennington’s company Law (Butterworths 1995)

[23] ibid at 804

[24] JF Corkery, Directors Powers and Duties (Melbourne 1987) at 136

[25] The Honourable Justice Ipp, “The Diligent Director”, (1997) 18 The Company Lawyer 162 at 166

[26] Directors’ fiduciary duties are owed to the company, and not to creditors, present or future or to shareholders as such. However, in defining the duty to act bona fide for the benefit of the company, the interests of creditors may in some circumstances be included, see Walker v Wimbourne (1976) 50 ALJR 446

[27] Finch, Company Directors: who cares about skill and care? Op cit, at 193

[28] Other weaknesses include being unable to pin point the precise time that directors should have predicted the company would not avoid insolvent liquidation, the fact liquidators are not prepared to fund an expensive action unless the success is likely and the fact the courts are unable to direct an award to a creditor who funded the action.

[29] [1998] 1 BCLC 76 at 680

[30] [1999] 1 BCLC 433

[31] [1997] 2 BCLC 530

[32] [1998] BCC 23

[33] Disqualification of Directors: No Hiding Place for the Unfit? The Chartered Association of Certified Accountants, certified Accountants Educational Trust, Research Report No 59, London 1998

[34] National Audit Office, Insolvency Service Executive Agency, Company Directors Disqualification – A follow Up Report, 1998/1999 House of Commons 424

[35] Law Commission and Scottish Law Commission, (1999) op,. cit

[36] J Birds “some brief Reflections on the State of Company Law” contr. In B. Rider, The Corporate Dimension, (Bristol: Jordans 1998) at 112

[37] The Law Commission’s Consultation Paper, (1998) op.cit., at 48

[38] Modernising Company Law Cm 5553

[39] Modernising Company Law, March 2005 para 3.3 www.dti.gov.uk

[40] A Hicks, Disqualification of Directors: No Hiding Place for the Unfit? The Chartered Association of Certified Accountants, Certified Accountants Educational rust, Research Report No 59, London, 1998 at 41

[41] The Law Commission consultation paper, (1998) op. cit., at para 52


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